Style drift.

As Central Banks plump their balance sheets with treasuries and mortgage backed securities (and stock market ETF shares … Japan), we should expect to see a push out the risk curve as investors seek yield.  I’ve written about this before.  I’ll be writing about it more, because it makes me nervous.

In trading, smart risk management teams keep an eye out for what we call “style drift”.  Essentially, a trader is good at trading one thing, opportunities in that strategy/market become harder to come by, so the trader starts changing.  He adds more leverage to the same strategy, or he removes some of the hedge (increasing return by lowering the cost of the hedge), or he drifts into ancillary markets (“I know a lot about trading oil, so I probably can make some money in distressed debt of downstream oil and gas companies” … that’s a big leap, but it’s in the right direction).

This morning I happened to come across a number of articles outlining this type of style drift.  I was going to include them all in the Links post, but I wanted to talk about them a little bit more.  None of these moves in a vacuum are a real concern (or even an irrational business move), but I see them as a trend to follow.

“Barclays May Hire More Traders as CEO Embraces Risk” – Bloomberg

Chief Executive Officer Jes Staley is encouraging the investment bank to take more risks and recapture market share after years of retrenchment. To give the division more capital to work with, he’s sold the bank’s African and European consumer networks.

Coming out of the 2008 Financial Crisis, Barclays announced that it was interested in generating 2/3 of its profits from retail and commercial banking and wealth management (Morningstar).  In large part, this was to head off calls for more regulatory oversight and public scrutiny.  Whatever the reason, this was the story investors were sold.

With returns on traditional financial practices lagging, Barclays shares are down 12% this year, and the CEO is looking to the trading desks to boost returns with distressed debt and CDOs.  The bank is looking to move up to $30 billion dollars of assets into the  riskier product lines, chasing the returns of the other major Investment Banks.  That’s a long way from running African and European retail banking networks.

“DRW leads high frequency trading charge into cryptocurrencies” – FT

Bitcoin v SP500
data from coindesk.com and Federal Reserve bank of St Louis

Two caveats: 1) proprietary trading firms are generally the least risk averse investors in the world, and 2) cryptocurrencies are probably the highest volatility asset class in the world.  This is where the high frequency guys should be playing.  They aren’t going to be able to play alone in this sandbox forever.

Trading desks make money when things move.  That’s the advantage of being a nimble active manager.  You can see the realized volatility in the chart above of the S&P 500 vs Bitcoins.  The more that stocks consistently creep up (10-20 basis points per day), the lower their volatility, and the more attractive Bitcoin’s 100% volatility becomes.

The risk isn’t in High Frequency Traders dominating the Bitcoin marketplace … god bless them on their new venture.  The risk is that Bitcoin trading becomes normalized and the volatility of other assets continues to decrease with easy money and implicit support for markets.  In that situation, do cryptocurrency skeptics like Jamie Dimon continue to forbid traders to trade the currency?  What if revenue is slipping and shares dip 12%?  What about 20%?  What if Goldman does it and is making a fortune?

Since October of 2007, the highest 30 day volatility in the S&P 500 was 81.2% annualized, and that was October/November 2008.  The average 30 day volatility in the Bitcoin chart above is 59.5% annualized.  My fear is not that traders trade Bitcoin, but that 60% annualized volatility becomes a normalized option on the risk curve.

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